Academic journal article Economic Review (Kansas City, MO)

How Do FOMC Projections Affect Policy Uncertainty?

Academic journal article Economic Review (Kansas City, MO)

How Do FOMC Projections Affect Policy Uncertainty?

Article excerpt

In January 2012, the Federal Open Market Committee (FOMC) began publicly releasing its participants' projections for the future value of the federal funds rate in its quarterly Summary of Economic Projections (SEP). These projections reflect each participant's view of appropriate monetary policy and are thus not unconditional forecasts. Highlighting the release of these projections, former FOMC Chair Ben Bernanke noted that "providing regular information about the future path of policy... has aided the public in forming policy expectations, reduced uncertainty [emphasis added], and made policy more effective."

However, the individual--and possibly conflicting--nature of these projections may not necessarily lead to lower uncertainty about future policy. A single participant's views about the appropriate future funds rate may not align with the views of the rest of the Committee. If participants notably disagree with each other about the appropriate path of policy, then the release of these projections may actually lead to an increase in uncertainly about future interest rates. Indeed, some monetary policy makers have suggested using these projections to communicate their disagreement. For example, in advocating for the release of the projections, Federal Reserve Bank of San Francisco President John C. Williams stated, "the range of our funds rate forecast would appropriately convey the disagreement and uncertainty we face" (Board of Governors 2017a).

Do these projections decrease or increase uncertainty about future policy? To answer this question, we examine how uncertainty about future interest rates, as measured by options prices from financial markets, changed after the FOMC began releasing its participants' projections for the appropriate federal funds rate. To isolate the releases' effects, we examine our market-based uncertainty measures immediately before and after FOMC meetings.

We find that overall uncertainty about future interest rates fell after the Committee began releasing its participants' interest rate projections. Specifically, we find the level of uncertainty on the day before and the day of an FOMC announcement decreased after the FOMC began releasing interest rate projections. However, we also find that uncertainty is significantly correlated with disagreement across participants' projections. Furthermore, we find changes in participant disagreement are helpful in explaining changes in interest rate uncertainty after an FOMC meeting. In summary, our results provide empirical support for the claims of both Bernanke and Williams.

I. Measuring Uncertainty Using Options from Financial Markets

To estimate uncertainty about future interest rates and examine how these uncertainty measures changed after the release of FOMC participants' policy projections in the SEP, we use prices from financial markets. (1) Specifically, we use Eurodollar options prices to estimate the probability distribution of possible outcomes for future interest rates (see Appendix for details on how the distribution is constructed). Eurodollar contracts are financial market instruments whose payoff depends on the London Interbank Offer Rate (LIBOR), a short-term borrowing rate for financial firms that closely tracks the federal funds rate. Options on these Eurodollar contracts are additional instruments that have a positive return only under specific outcomes for future interest rates.

The price of a Eurodollar option today reflects financial market participants' beliefs about future short-term interest rates. For example, a given option may have a positive payoff only if the LIBOR rises above 2 percentage points at the end of the next year. A high price for this option suggests financial market participants believe that short-term interest rates are highly likely to be above the 2 percent threshold in a year. In contrast, a price near zero suggests financial market participants believe this event is quite unlikely. …

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